Taxes on Renewable Natural Capital (water; timber)

Any fee, charge or tax charged on the extraction and/or use of renewable natural capital (e.g. timber or water). Following the user-pays principle, these levies help to internalize the true cost of ecosystem degradation by increasing the price of the natural capital “consumed”.

Key words: Charge; fee; tax; renewable natural resources; water; timber; forests;

How does it work?

Natural capital is the sum of the world’s stocks of natural assets that include geology, soil, air, water and all living things. This stock is made of renewable (e.g. water, plants and animals) and non-renewable (e.g. minerals) resources from which people derive many different benefits or flows. These flows provide value to business and society, a value that can be monetized and taxed for different purposes. Natural capital therefore represents a store of value and is no different from other forms of capital that are in some way taxed, such as financial and human capital. Properly designed income and consumption taxes should uniformly tax different forms of capital. However, fiscal systems have in reality allowed (if not incentivized) severe depletion of natural resources due to public sector and market failures. The objective of tax reforms on natural capital is therefore to provide incentives to consume natural resources and benefit from ecosystem services sustainably, while taxing undue rents. For simplicity the platform frames taxation on natural capital as different solutions: fuel taxes; taxes on fisheries (forthcoming); taxes on renewable natural capital and taxes; and taxes on non-renewable natural capital (forthcoming).

In addition to generating new revenues—even if tax reforms might be designed to be neutral to the taxpayer—natural capital taxes, fees and levies can help resolve market failures by internalizing the true cost of depleting scarce natural resources. The idea is simple: people and firms will consume less if the price of what is consumed increases, thus allowing renewable resources to recover. If the revenue generated from these taxes is reinvested in replenishing the natural stock, it can directly or indirectly help to substitute or renew the lost capital. For example, revenues from a tax on wood in Mali are used to cover the costs of public support to maintain forests and to finance collective investments in forest communities. Similarly 60 per cent of the payments received from the Latvian Natural Resource Tax is transferred to the local governments or environmental protection.

Taxes and levies applied on natural capital include volumetric use charges (e.g. the volume of timber harvested per cubic meter; or metric water fees); resource rentals or royalties; fees or charges levied at the point of issue or allocation; and/or surcharges levied at the point of transfer or trade. Another option that is comparable to taxation is the requirement for firms to bid for the right to exploit a certain stock of renewable natural resources. This fiche focuses on taxation in the water and forest sectors.

Water taxation has historically been paired with the establishment of a regulatory framework that oversees the provision of access to clean water to the wider population (a basic human right). In many countries, water utilities mediate between the government and the consumer and collect mandatory taxes and levies from different users for the abstraction of water resources. These are often not charged on the full price of volumetric consumption of water, but set at a value sufficient to recover the costs of water treatment, storage, and transportation, and wastewater treatment. Water services are paid either as a set amount—lump sum—metred based on actual consumption, or a combination of the two. Access to water for irrigation, industry and energy is usually governed by different legislative frameworks to household use, with differentiated charges applied which might be subsidized either explicitly or implicitly. The category includes general (local and national) taxes and special levies charged in exchange for a service, for example water and wastewater bills, property assessments, fees/charges to improve the quality of the water and developer fees which may fund water infrastructure rehabilitation, etc. It is common for tax proceedings to be earmarked for water management services or to finance Payments for Ecosystem Services schemes such as in Mexico, where an earmarked share of water use fees goes towards the hydrological environmental services programme. The idea of water taxes to achieve sustainable consumption levels has most recently emerged in relation to scarcity and frequent droughts in the Northern hemisphere and particularly in California, USA. European countries (e.g. Denmark, France and the Netherlands) have established taxes, charges and levies to provide an incentive for efficient water use. Tax reforms can also be designed to encompass incentives for more sustainable use of water resources and stimulate the adoption of innovative water technologies. For example, in Australia the Government introduced a range of special income tax deductions to encourage irrigators to adopt more water-efficient and water-saving technologies during a recent drought.

Similarly, countries tax the forest sector and particularly timber production to achieve sustainable forest management objectives and/or meet fiscal resource mobilization targets. The most used forms of taxation are stumpage fees, concessions fees, royalties based either on the volume or the value of the timber harvested and export levies (e.g. Ghana has applied rates from 1 to 2 per cent on timber exports). The fees applied to processed goods such as sawn wood or plywood, are classified as postharvest fees. In countries where a large proportion of timber is processed for export, but illegally harvested, postharvest fees can raise significant revenues. However, they may undermine the sustainability of the management of forests. Other instruments, including pre-harvesting fees and concession auctioning, are also possible. For example, the area tax (or concession fee) is a tax charged on an equal and annual basis to forest hectares given under concession. Concession fees can be determined through bidding, such as in Cameroon where the examination of a technical offer is weighted 30 per cent in the allocation formula along with the proposal for the per hectare annual area fee (weighted 70 per cent). The Government recently introduced a floor price equivalent to €1.5 per hectare and options for inflation-linked updates. The determination of area fees through bidding—€4-6 per hectare a year on average—resulted in far higher revenues than originally calculated by the Government.

Traditionally forest taxation has not been limited to a single instrument, and its structure may become over-complicated. A case in point is the complex legislation in poor countries where timber is a core source of tax revenues. For example in Liberia in the mid-2000s, a tree could have been subjected to over 20 regulatory provisions including taxes, fees, and other charges, based on its volume, species, degree of processing, and other specifications. The complexity of the taxation system has rarely been a measure of effectiveness, but is often a sign of the need for for simplification and better enforcement. In developing countries a mix of area fees set through competitive bidding and export or post-harvesting taxation has been suggested. The taxation structure should be dynamically linked to its impact on ecosystems and biodiversity: for example, the overexploitation of some commercial high value species (logging of which is detrimental for the environment) may or may not be incentivized by taxation. Taxes can also provide incentives for more sustainable use of forest resources, for example by providing discounts and tax breaks for the companies that obtain certain certifications. While wood and timber are the main sources of taxation for forests, non-wood forest products (e.g. nuts, seeds, berries, mushrooms, oils, foliage, medicinal plants, etc.) can also be taxed.

In addition to taxation on water resources and forest products, other types of taxes and charges may also be relevant, such as raising tariffs related to sales, export, property and corporate profit taxes when related or benefiting to the forest or water sectors. The level of taxation and subsidies in sectors such as agriculture and energy can also influence the relative price of wood and non-wood products and in certain cases can exacerbate negative effects on natural capital. For example, in India and Mexico subsidized electricity for farmers to pump groundwater has led to serious groundwater depletion. In Ecuador and Indonesia, fiscal incentives related to palm oil production (e.g. subsidies or tax exemptions for fertilizers and pesticides, fiscal incentives for access to/acquisition of rural land) contribute to deforestation.

Stakeholders

  • Regulatory entity/ies: The authority(s) responsible for submitting the relevant draft bill for approval in the national/regional assembly.
  • Revenue collection entity/ies: The tax is collected by the revenue authority from retailers or consumers. The earned income might be transferred to the treasury or allocated to a specified budget (e.g. a local water fund).
  • Tax base/payer: The consumer/firm that pays the tax/fee over the use/consumption of natural capital.  

Potential in monetary terms

Revenues from taxation vary greatly across countries, depending on the tax rate applied, the number of products covered and the tax base. In resource-rich developing countries, natural capital levies can represent a significant share of taxes with some forest-rich countries (e.g. Cambodia and Cameroon) having undertaken reforms to increase the fiscal revenues. Reviews have shown large variations that are explained by the different policy objectives and economic fundamentals: for example, in Africa the average charge collection (US$/m3) for industrial Roundwood ranged from 0.17 in Burundi up to 59.24 in Mauritius. However, studies of timber taxation often highlight a low level of taxes compared to the value of the harvest, indicating the potential for increasing public revenues. The potential for revisiting the current pricing of water services is high, particularly in developing countries. Through public water utilities, many developing countries in fact directly or indirectly subsidize water overconsumption while imposing an unnecessary fiscal burden. In developed countries water prices tend to be close to cost recovery levels. In a few countries, such as Singapore, full cost recovery has been achieved along with targeted help for low-income families. More detailed information on revenues can be accessed from the the OECD database on Policy Instruments for the Environment, for selected countries.  

When is it feasible?

Legal and/or other feasibility requirements

A law is usually required to introduce or amend the tax code. Feasibility studies are necessary to forecast the economic, social and environmental impacts of the suggested taxation. In federal states different jurisdictions might be able introduce water and forest taxes/fees. The levying of water taxes/fees can also be decentralized at the municipal level. 

Minimum investment required and running costs

The introduction of water/forest taxation requires a legal and economic assessment as well as technical inputs to amend the tax code. Advocacy and awareness-raising campaigns are necessary to facilitate the approval of the legislation and to balance different interests, as well as to modify perceptions among policymakers and the general public. Once approved, administrative burdens vary considerably, but are generally contained and covered by the overall revenue administration. 

In what context/when it is more appropriate

Natural capital taxes/fees that aim to capture the natural resource rent from the exploitation of natural resources, -such as forests, will be most relevant to resource-rich countries in terms of revenue generation potential. However, it might also be the opposite, i.e. the scarcity of renewable natural capital (e.g. increasing water scarcity) could provide the main rationale for reforming the tax system.

Natural capital taxes/fees are appropriate in most economic and social contexts. However, the specific economic and social context should guide their design, including selection of the appropriate tax rate, the timing/phasing-in of implementation and the identification of exceptions or complementary measures (e.g. income support for poor households, incentives for the adoption of more efficient technologies). In the countries that directly or indirectly subsidize unsustainable use of renewable resources, the priority should be to phase out such subsidies.

An initial assessment of enforcement agencies can provide guidance on the selection of the instruments. In particular administrative capacity and the risk of corruption might suggest a simpler tax and incentive system.

What are the main risks and challenges?

Pros

  • Natural capital taxation is an efficient form of taxation that might generate a “double dividend”. For example, shifting the tax burden from labour to combatting the depletion of natural assets can benefit both the economy by encouraging employment and income and the environment by promoting a more sustainable use of natural resources. It is considered efficient by economic theory as a non-distorting form of taxation.
  • Property rights in natural capital largely belong to the wider public or society, rather than to private citizens. They can be best defended through fiscal and policy instruments as a result.
  • Revenues generated can support priority public investments or help to reduce other taxes. For example, revenues generated through a levy on timber can be used to support reforestation projects; revenues from water taxes can support public expenditure in water infrastructure which will help to expand coverage, improve water quality, and increase access and services to poor communities etc.
  • Natural capital taxation provides a regular and reliable source of income and has the potential to generate significant additional revenue.
  • Given the pre-existence of a tax collection system, the cost of collection and set-up is usually contained. 

Cons

  • Introducing natural capital levies requires considerable public and political support. The introduction of natural capital taxes/fees may cause resistance with stakeholders and segments of society that see their income reduced. For example, fiscal reforms in the water sector, in particular those involving water pricing structures, can have potential negative impacts on the poor and on the competitiveness of water-intensive industries (including agriculture). Thus there may be considerable resistance to the introduction of the tax, making it politically or socially unfeasible and/or unsustainable.
  • The effectiveness of the natural capital tax/fee depends on the price elasticity. In case demand for a certain renewable resource is relatively inelastic, the tax may have a very limited effect on the consumption of renewable natural capital. 

Risks

  • The tax/fee might be regressive and unfair for a certain (vulnerable) segment of the population; the cost of the natural capital taxation may be too high for poorer households. Moreover, even when present, the support mechanisms designed to balance the tax’s impact on the poor might not be effective or efficient.
  • Assessing the value of natural capital is a significant challenge in view of the diversity of natural stocks and flows. Setting the level of the tax/fee at the right level can be difficult when the total volume and the capacity/potential for renewal of the natural capital stock is unknown. The tax rate might then not be set at the appropriate level to correct negative externalities.
  • The revenue-raising objective may result in tax rates that are higher than the estimated value of the social externalities. Such tax rates increase the cost of certain activities or goods beyond the correction needed to incorporate externalities, which may result in a change in market behaviour. As a consequence, the revenues collected through the levy may actually decrease.
  • Instruments that address one particular resource or activity may lead to substitution of an even less environmentally friendly resource (e.g. non-renewables) or one that is less efficient on a life-cycle basis. Substitution effects need to be taken into account to avoid conflict with overall environmental objectives. For example, forest taxes can modify the relative prices of wood and timber products: large difference in tax rates among different categories/products can lead to consumers switching among products.
  • Water taxes can multiply the impact of water price increases due to droughts, bearing potentially large negative effects on the economy.
  • If neighbouring countries (or states) apply a lower rate of taxation, consumers might simply shift to those territories. If the price difference is substantial and borders are porous, smuggling for certain natural capital assets might emerge.

How can the design be ameliorated to improve the impact?

Natural capital is under significant pressure across the world and demographic and economic projections suggest that pressures are likely to grow. Examples include deforestation, depletion of fish stocks, soil erosion, or toxic emissions that harm human health. Natural capital taxation can counter the depletion of the resource stock and thus safeguard our environment, while generating significant revenues at the same time. Research shows that natural capital levies do result in decreased demand for a renewable resource product, service or activity. For example, a study undertaken by the European Commission in 2011 found that volumetric charges on drinking and industrial water in the Netherlands and Cyprus have reduced consumption by between 8 and 40 per cent, depending on user group. In Australia the Government has experimented with a range of tax deductions to encourage irrigators to adopt more water-efficient and water-saving technologies.

Setting the tariff or charge at the “right” level is central for effectiveness and impact. The charge, fee or tax should be commensurate with the negative externality (e.g. over-consumption) it addresses. Moreover, trade-offs exist between maximizing the tax revenue versus choosing the most effective rate for achieving a positive environmental impact. Tax measures also need to be regularly reviewed to maintain their resource efficiency and respond to market signals: the impact of a tax measure may be, for example, eroded by inflation. Updates of taxes/fees rates, based on price or volume percentages, reduce these erosion effects and can be simpler to implement and more effective.

Natural capital and particularly forests and water play an important role in the livelihoods and welfare of a vast number of people. They need to be preserved in order to be shared with equity. For example, the introduction of regulatory reforms and forest taxes in Cameroon—a country with significant volumes of wood exports—gave a significant boost to the economy, creating direct and indirect employment as well as additional tax revenues. When a share of the revenue is reinvested in preserving the natural capital stock—such as in the example above of Cameroon—the impact on the environment and local communities can be magnified.

Companion incentive schemes and tax breaks can increase the social and environment impact of taxation. For example, the provision of subsidies for acquiring efficient irrigation technology by farmers in Andhra Pradesh and Gujarat (India) improved crop yields and quality, and led to marked improvements in farmers’ incomes and living standards. Similarly a mix of regulatory and price approaches can further enhance the impact, for example by excluding certain practices or technologies or introducing sustainable standards in forest or water management.

Moreover, natural capital taxes/fees may induce firms not only to reduce resource consumption or pollution to the desired level but to explore and develop new and even less resource-intensive technologies in order to pay less taxes. As such, natural capital levies can offer businesses appropriate incentives to develop new technologies and improve efficiency and environmental performance.

The social impact largely depends on the distributional effects of the measure (i.e. how regressive the income effect of the measure is). By addressing over-consumption through price signals, natural capital taxation may affect lower income households proportionally more than higher income households. A negative distributional impact can be counterbalanced with corrective measures such as exemptions for lower-income households. Distributional impacts as well as concerns about competitiveness should be addressed through policy design and complementary measures where needed. Examples of mitigation measures/design considerations to address negative distributional impacts of water pricing include setting a low or zero tariff for the first few units of water consumed to allow poor households access to water services at little or no cost. Some countries charge the full tariff on all users and provide a targeted lump-sum refund to vulnerable groups. For example in Chile the Government provides means-tested financial support to low-income families which ensures beneficiaries do not pay more than 5 per cent of household income on water bills.

Finally, good communication is critical for establishing and maintaining public and political support. Education and awareness-raising are powerful supporting tools for environmental fiscal reforms. Similarly the governance of the tax/fee system and the auditing of expenditures are necessary instruments to guarantee long- lasting impact and good public investment practices.